World politicians, business leaders, charities and pressure groups are meeting in Davos at the 2022 World Economic Forum. Normally this event takes place in January each year, but it was postponed to this May because of Covid-19 and is the first face-to-face meeting since January 2020.
The meeting takes place amid a series of crises facing the world economy. The IMF’s Managing Director, Kristalina Georgieva, described the current situation as a ‘confluence of calamities’. Problems include:
- Continuing hangovers from Covid have caused economic difficulties in many countries.
- The bounceback from Covid has led to demand outpacing supply. The world is suffering from a range of supply-chain problems and shortages of key materials and components, such as computer chips.
- The war in Ukraine has not only caused suffering in Ukraine itself, but has led to huge energy and food price increases as a result of sanctions and the difficulties in exporting wheat, sunflower oil and other foodstuffs.
- Supply shocks have led to rising global inflation. This will feed into higher inflationary expectations, which will compound the problem if they result in higher prices and wages in response to higher costs.
- Central banks have responded by raising interest rates. These dampen an already weakened global economy and could push the world into recession.
- Global inequality is rising rapidly, both within countries and between countries, as Covid disruptions and higher food and energy prices hit the poor disproportionately. Poor people and countries also have a higher proportion of debt and are thus hit especially hard by higher interest rates.
- Global warming is having increasing effects, with a growing incidence of floods, droughts and hurricanes. These lead to crop failures and the displacement of people.
- Countries are increasingly resorting to trade restrictions as they seek to protect their own economies. These slow economic growth.
World leaders at Davos will be debating what can be done. One approach is to use fiscal policy. Indeed, Kristalina Georgieva said that her ‘main message is to recognise that the world must spend the billions necessary to contain Covid in order to gain trillions in output as a result’. But unless the increased expenditure is aimed specifically at tackling supply shortages and bottlenecks, it could simply add to rising inflation. Increasing aggregate demand in the context of supply shortages is not the solution.
In the long run, supply bottlenecks can be overcome with appropriate investment. This may require both greater globalisation and greater localisation, with investment in supply chains that use both local and international sources.
International sources can be widened with greater investment in manufacturing in some of the poorer developing countries. This would also help to tackle global inequality. Greater localisation for some inputs, especially heavier or more bulky ones, would help to reduce transport costs and the consumption of fuel.
With severe supply shocks, there are no simple solutions. With less supply, the world produces less and becomes poorer – at least temporarily until supply can increase again.
- Draw an aggregate demand and supply diagram (AD/AS or DAD/DAS) to illustrate the effect of a supply shock on output and prices.
- Give some examples of supply-side policies that could help in the current situation.
- What are the arguments for and against countries using protectionist policies at the current time?
- What policies could countries adopt to alleviate rapid rises in the cost of living for people on low incomes? What problems do these policies pose?
- What are the arguments for and against imposing a windfall tax on energy companies and using the money to support poor people?
- If the world slips into recession, should central banks and governments use expansionary monetary and fiscal policies?
On March 23, Rishi Sunak, the UK’s Chancellor of the Exchequer, delivered his Spring Statement, in which he announced changes to various taxes and grants. These measures were made against the background of rising inflation and falling living standards.
CPI inflation, currently at 6.2%, is still rising and the Office for Budget Responsibility forecasts that inflation will average 7.4% this year. The poor spend a larger proportion of their income on energy and food than the rich. With inflation rates especially high for gas, electricity and basic foodstuffs, the poor have been seen their cost of living rise by considerably more than the overall inflation rate.
According to the OBR, the higher inflation, by reducing real income and consumption, is expected to reduce the growth in real GDP this year from the previously forecast 6% to 3.8% – a much smaller bounce back from the fall in output during the early stages of the pandemic. Despite this growth in GDP, real disposable incomes will fall by an average of £488 per person this year. As the OBR states:
With inflation outpacing growth in nominal earnings and net taxes due to rise in April, real living standards are set to fall by 2.2 per cent in 2022/23 – their largest financial year fall on record – and not recover their pre-pandemic level until 2024/25.
The Chancellor announced a number of measures, which, he argued, would provide relief from rises in the cost of living.
- Previously, the Chancellor had announced that national insurance (NI) would rise by 1.25 percentage points this April. In the Statement he announced that the starting point for paying NI would rise from a previously planned £9880 to £12 570 (the same as the starting point for income tax). This will more than offset the rise in the NI rate for those earning below £32 000. This makes the NI system slightly more progressive than before. (Click here for a PowerPoint of the chart.)
- A cut in fuel duty of 5p per litre. The main beneficiaries will be those who drive more and those with bigger cars – generally the better off. Those who cannot afford a car will not benefit at all, other than from lower transport costs being passed on in lower prices.
- The 5% VAT on energy-saving household measures such as solar panels, insulation and heat pumps will be reduced to zero.
- The government’s Household Support Fund will be doubled to £1bn. This provides money to local authorities to help vulnerable households with rising living costs.
- Research and development tax credits for businesses will increase and small businesses will each get another £1000 per year in the form of employment allowances, which reduce their NI payments. He announced that taxes on business investment will be further cut in the Autumn Budget.
- The main rate of income tax will be cut from 20% to 19% in two years’ time. Unlike the rise in NI, which only affects employment and self-employment income, the cut in income tax will apply to all incomes, including rental and savings income.
The Chancellor announced that public finances are stronger than previously forecast. The rapid growth in tax receipts has reduced public-sector borrowing from £322 billion (15.0 per cent of GDP) in 2020/21 to an expected £128 billion (5.4 per cent of GDP) in 2021/22, £55 billion less than the OBR forecast in October 2021. This reflects not only the growth in the economy, but also inflation, which results in fiscal drag.
Fiscal drag is where rises in nominal incomes mean that the average rate of income tax rises. As tax thresholds for 2022/23 are frozen at 2021/22 levels, a greater proportion of incomes will be taxed at higher rates and tax-free allowances will account for a smaller proportion of incomes. The higher the rate of increase in nominal incomes, the greater fiscal drag becomes. The higher average rate of tax drags on real incomes and spending. On the other hand, the extra tax revenue reduces government borrowing and gives the government more room for extra spending or tax cuts.
The growth in poverty
With incomes of the poor not keeping pace with inflation, many people are facing real hardship. While the Spring Statement will provide a small degree of support to the poor through cuts in fuel duty and the rise in the NI threshold, the measures are poorly targeted. Rather than cutting fuel duty by 5p, a move that is regressive, removing or reducing the 5% VAT on gas and electricity would have been a progressive move.
Benefits, such as Universal Credit and the State Pension, are uprated each April in line with inflation the previous September. When inflation is rising, this means that benefits will go up by less than the current rate of inflation. This April, benefits will rise by last September’s annual inflation rate of 3.1% – considerably below the current inflation rate of 6.2% and the forecast rate for this year of 7.4%. This will push many benefit recipients deeper into poverty.
One measure rejected by Rishi Sunak is to impose a temporary windfall tax on oil companies, which have profited from the higher global oil prices. Such taxes are used in Norway and are currently being considered by the EU. Tax revenues from such a windfall tax could be used to fund benefit increases or tax reductions elsewhere and these measures could be targeted on the poor.
- Overview of the March 2022 Economic and fiscal outlook
Office for Budget Responsibility (23/3/22)
- Spring Statement: Key points at a glance
BBC News (23/3/22)
- Spring statement 2022: key points at a glance
The Guardian, Richard Partington and Jessica Elgot (23/3/22)
- People face biggest drop in living standards since 1956
BBC News (23/3/22)
- Spring Statement: Rishi Sunak accused of not doing enough for poorest households
BBC News (24/3/22)
- Chancellor provides minimal help to households on cost of living crisis
Financial Times, Chris Giles (23/3/22)
- Britain’s poorest left to bear brunt of squeeze on cost of living
Financial Times, Delphine Strauss (23/3/22)
- Spring statement: How does Rishi Sunak’s national insurance change affect you?
Sky News, Daniel Dunford and Ganesh Rao (24/3/22)
- Spring Statement 2022 – An initial response from IFS researchers
Institute for Fiscal Studies Press Release, Stuart Adam, Carl Emmerson, Paul Johnson, Helen Miller, Isabel Stockton, Tom Waters and Ben Zaranko (23/3/22)
- Chancellor prioritises his tax cutting credentials over low-and-middle income households with £2 in every £3 of new support going to the top half
Resolution Foundation press release (23/3/22)
- Richest handed £480 boost in Spring Statement, say researchers
- UK’s most vulnerable face crunch as Rishi Sunak helps better-off
The Guardian, Larry Elliott and Heather Stewart (23/3/22)
- Rishi Sunak tackled over failure to help poorest families
The Guardian, Richard Partington and Aubrey Allegretti (24/3/22)
- A Spring Statement for White Wealth Drivers
Byline Times, Stan Norris (23/3/22)
- Rishi Sunak’s Fiscal Drag Race
Evening Standard, Jack Kessler (23/3/22)
- Rishi Sunak fails to address the hit to living standards
Financial Times, Martin Wolf (23/3/22)
- Why Rishi Sunak refused a windfall tax on oil and gas companies
The New Statesman, Philippa Nuttall (23/3/22)
OBR data and analysis
- Are the changes made to national insurance by the Chancellor progressive or regressive? Could they have been made more progressive and, if so, how?
- What are the arguments for and against cutting income tax from 20% to 19% in two years’ time rather than reversing the current increases in national insurance at that point?
- What will determine how rapidly (if at all) public-sector borrowing decreases over the next few years?
- What are automatic fiscal stabilisers? How does their effect vary with the rate of inflation?
- Examine the public finances of another country. Are the issues similar to those in the UK? Recommend fiscal policy measures for your chosen country and provide a justification.
The suffering inflicted on the Ukrainian people by the Russian invasion is immense. But, at a much lower level, the war will also inflict costs on people in countries around the world. There will be significant costs to households in the form of even higher energy and food price inflation and a possible economic slowdown. The reactions of governments and central banks could put a further squeeze on living standards. Stock markets could fall further and investment could decline as firms lose confidence.
Russia is the world’s second largest oil supplier and any disruption to supplies will drive up the price of oil significantly. Ahead of the invasion, oil prices were rising. At the beginning of February, Brent crude was around $90 per barrel. With the invasion, it rose above $100 per barrel.
Russia is also a major producer of natural gas. The EU is particularly dependent on Russia, which supplies 40% of its natural gas. With Germany halting approval of the major new gas pipeline under the Baltic from Russia to Germany, Nord Stream 2, the price of gas has rocketed. On the day of the invasion, European gas prices rose by over 50%.
Nevertheless, with the USA deciding not to extend sanctions to Russia’s energy sector, the price of gas fell back by 32% the next day. It remains to be seen just how much the supplies of oil and gas from Russia will be disrupted over the coming weeks.
Both Russia and Ukraine are major suppliers of wheat and maize, between them responsible for 14% of global wheat production and 30% of global wheat exports. A significant rise in the price of wheat and other grains will exacerbate the current rise in food price inflation.
Russia is also a significant supplier of metals, such as copper, platinum, aluminium and nickel, which are used in a wide variety of products. A rise in their price has begun and will further add to inflationary pressures and supply-chain problems which have followed the pandemic.
The effect of these supply shocks can be illustrated in a simple aggregate demand and supply diagram (see Figure 1), which shows a representative economy that imports energy, grain and other resources. Aggregate demand and short-run aggregate supply are initially given by AD0 and SRAS0. Equilibrium is at point a, with real national income (real GDP) of Y0 and a price index of P0.
The supply shock shifts short-run aggregate supply to SRAS1. Equilibrium moves to point b. The price index rises to P1 and real national income falls to Y1. If it is a ‘one-off’ cost increase, then the price index will settle at the new higher level and GDP at the new lower level provided that real aggregate demand remains the same. Inflation will be temporary. If, however, the SRAS curve continues to shift upwards to the left, then cost-push inflation will continue.
These supply-side shocks make the resulting inflation hard for policymakers to deal with. When the problem lies on the demand side, where the inflation is accompanied by an unsustainable boom, a contractionary fiscal and monetary policy can stabilise the economy and reduce inflation. But the inflationary problem today is not demand-pull inflation; it’s cost-push inflation. Disruptions to supply are both driving up prices and causing an economic slowdown – a situation of ‘stagflation’, or even an inflationary recession.
An expansionary policy, such as increasing bond purchases (quantitative easing) or increasing government spending, may help to avoid recession (at least temporarily), but will only exacerbate inflation. In Figure 2, aggregate demand shifts to AD2. Equilibrium moves to point c. Real GDP returns to Y0 (at least temporarily) but the price level rises further, to P2. (Click here for a PowerPoint of the diagram.)
A contractionary policy, such as raising interest rates or taxes, may help to reduce inflation but will make the slowdown worse and could lead to recession. In the diagram, aggregate demand shifts to AD3. Equilibrium moves to point d. The price level returns to P0 (at least temporarily) but real income falls further, to Y3.
In other words, you cannot tackle both the slowdown/recession and the inflation simultaneously by the use of demand-side policy. One requires an expansionary fiscal and/or monetary policy; the other requires fiscal and/or monetary tightening.
Then there are other likely economic stresses. If NATO countries respond by increasing defence expenditure, this will put further strain on public finances.
Sentiment is a key driver of the economy and prices. Expectations tend to be self-fulfilling. So if the war in Ukraine undermines confidence in stock markets and the real economy and further raises inflationary expectations, this pessimistic mood will tend in itself to drive down share prices, drive up inflation and drive down investment and economic growth.
- How will Russia’s invasion of Ukraine hit the global economy?
Financial Times, Chris Giles, Jonathan Wheatley and Valentina Romei (25/2/22)
- Ukraine conflict raises the possibility of stagflation
Financial Times, The Editorial Board (25/2/22)
- Five ways the Ukraine war could push up prices
BBC News, Laura Jones (5/3/22)
- Jason Furman cautions against reading too much into the initial market reactions to Russia’s invasion
interest.co.nz, Jason Furman (26/2/22)
- Putin’s war promises to crush the global economy with inflation and much slower growth
Market Watch, Nouriel Roubini (25/2/22)
- Roubini: 6 Financial, Economic Risks of Russia-Ukraine War
ThinkAdvisor, Janet Levaux (25/2/22)
- Fed tightening plans now contending with war, possible oil shock
Reuters, Howard Schneider and Jonnelle Marte (24/2/22)
- The invasion of Ukraine changed everything for Wall Street
CNN, Julia Horowitz (27/2/22)
- Why the Russian invasion will have huge economic consequences for American families
CNN, Matt Egan (24/2/22)
- European gas prices soar and oil tops $105 after Russia attacks Ukraine
Financial Times, Neil Hume, Emiko Terazono and Tom Wilson (24/2/22)
- Five essential commodities that will be hit by war in Ukraine
The Conversation, Sarah Schiffling and Nikolaos Valantasis Kanellos (24/2/22)
- Ukraine: ‘I’m surprised the oil price hasn’t hit US$130 a barrel yet’ – energy trading expert Q&A
The Conversation, Adi Imsirovic (25/2/22)
- Ukraine crisis: Warning UK energy bills could top £3,000 a year
BBC News, Michael Race (25/2/22)
- Putin’s energy shock: The economic realities of invasion
BBC News, Faisal Islam (25/2/22)
- Fears of UK food and fuel prices rising due to war
BBC News, Oliver Smith & Michael Race (26/2/22)
- Ukraine conflict: What is Swift and why is banning Russia so significant?
BBC News, Russell Hotten (27/2/22)
- Ukraine conflict: How reliant is Europe on Russia for oil and gas?
BBC News, Jake Horton & Daniele Palumbo (25/2/22)
- Ukraine crisis complicates ECB’s path to higher rates
Reuters, Francesco Canepa and Balazs Koranyi (24/2/22)
- Russia and the West are moving towards all out economic war
Al Jazeera, Maximilian Hess (24/2/22)
- If there is a negative supply shock, what will determine the size of the resulting increase in the price level and the rate of inflation over the next one or two years?
- How may expectations affect (a) the size of the increase in the price level; (b) future prices of gas and oil?
- Why did stock markets rise on the day after the invasion of Ukraine?
- Argue the case for and against relaxing monetary policy and delaying tax rises in the light of the economic consequences of the war in Ukraine.
With the onset of the pandemic in early 2020, stock markets around the world fell dramatically, with many indices falling by 30% or more. In the USA, the Dow Jones fell by 37% and the Nasdaq fell by 30%. In the UK, the FTSE 100 fell by 33% and the FTSE 250 by 41%.
But with a combination of large-scale government support for their economies, quantitative easing by central banks and returning confidence of investors, stock markets then made a sustained recovery and have continued to grow strongly since – until recently, that is.
With inflation well above target levels, central banks have ended quantitative easing (QE) or have indicated that they soon will. Interest rates are set to rise, if only slowly. The Bank of England raised Bank Rate from its historic low of 0.1% to 0.25% on 16 December 2021 and ceased QE, having reached its target of £895 billion of asset purchases. On 4 February 2022, it raised Bank Rate to 0.5%. The Fed has announced that it will gradually raise interest rates and will end QE in March 2022, and later in the year could begin selling some of the assets it has purchased (quantitative tightening). The ECB is not ending QE or raising interest rates for the time being, but is likely to do so later in the year.
At the same time economic growth is slowing, leading to fears of stagflation. Governments are likely to dampen growth further by tightening fiscal policy. In the UK, national insurance is set to rise by 1.25 percentage points in April.
The slowdown in growth may discourage central banks from tightening monetary policy more than very slightly. Indeed, in the light of its slowing economy, the Chinese central bank cut interest rates on 20 January 2022. Nevertheless, it is likely that the global trend will be towards tighter monetary policy.
The fears of slowing growth and tighter monetary and fiscal policy have led many stock market investors to predict an end to the rise in stock market prices – an end to the ‘bull run’. This belief was reinforced by growing tensions between Russia and NATO countries and fears (later proved right) that Russia might invade Ukraine with all the turmoil in the global economy that this would entail. Stock market prices have thus fallen.
The key question is what will investors believe. If they believe that share prices will continue to fall they are likely to sell. This has happened since early January, especially in the USA and especially with stocks in the high-tech sector – such stocks being heavily represented in the Nasdaq composite, a broad-based index that includes over 2500 of the equities listed on the Nasdaq stock exchange. From 3 January to 18 February the index fell from 15 833 to 13 548, a fall of 14.4%. But will this fall be seen as enough to reflect the current economic and financial climate. If so, it could fluctuate around this sort of level.
However, some may speculate that the fall has further to go – that indices are still too high to reflect the earning potential of companies – that the price–earnings ratio is still too high for most shares. If this is the majority view, share prices will indeed fall.
Others may feel that 14.4% is an overcorrection and that the economic climate is not as bleak as first thought and that the Omicron coronavirus variant, being relatively mild for most people, especially if ‘triple jabbed’, may do less economic damage than first feared. In this scenario, especially if the tensions over Ukraine are diffused, people are likely to buy shares while they are temporarily low.
But a lot of this is second-guessing what other people will do – known as a Keynesian beauty contest situation. If people believe others will buy, they will too and this will push share prices up. If they think others will sell, they will too and this will push share prices down. They will all desperately wish they had a crystal ball as they speculate how people will interpret what central banks, governments and other investors will do.
- What changes in real-world factors would drive investors to (a) buy (b) sell shares at the current time?
- How does quantitative easing affect share prices?
- What is meant by the price-earnings ratio of a share? Is it a good indicator as to the likely movement of that share’s price? Explain.
- What is meant by a Keynesian beauty contest? How is it relevant to the stock market?
- Distinguish between stabilising and destabilising speculation and illustrate each with a demand and supply diagram. Explain the concept of overshooting in this context.
- Which is more volatile, the FTSE 100 or the FTSE 250? Explain.
- Read the final article linked above. Were the article’s predictions about the Fed meeting on 26 January borne out? Comment.
Inflation across the world has been rising. This has been caused by a rise in aggregate demand as the global economy has ‘bounced back’ from the pandemic, while supply-chain disruptions and tight labour markets constrain the ability of aggregate supply to respond to the rise in demand.
But what of the coming months? Will supply become more able to respond to demand as supply-chain issues ease, allowing further economic growth and an easing of inflationary pressures?
Or will higher inflation and higher taxes dampen real demand and cause growth, or even output, to fall? Are we about to enter an era of ‘stagflation’, where economies experience rising inflation and economic stagnation? And will stagnation be made worse by central banks which raise interest rates to dampen the inflation but, in the process, dampen spending.
Despite the worries of central banks, with inflation being higher than forecast a few months ago, forecasts (e.g. the OECD’s) are still for inflation to peak fairly soon and then to fall back to around 2 to 3 per cent by the beginning of 2023 – close to central bank target rates.
In the UK, annual CPI inflation reached 5.4% in December 2021. The UK Treasury’s January 2022 new monthly forecasts for the UK economy by 15 independent institutions give an average forecast of 4.0% for CPI inflation for 2022. In the USA, annual consumer price inflation reached 7 per cent in December 2021, but is forecast to fall to just over the target rate of 2% by the end of 2022.
If central banks respond to the current high inflation by raising interest rates more than very slightly and by stopping quantitative easing (QE), or even engaging in quantitative tightening (selling assets purchased under previous QE schemes), there is a severe risk of a sharp slowdown in economic activity. Household budgets are already being squeezed by the higher prices, especially energy and food prices. And people will face higher taxes as governments seek to reduce their debts, which soared with the Covid support packages during the pandemic.
The Fed has signalled that it will end its bond buying (QE) programme in March 2022 and may well raise interest rates at the same time. Quantitative tightening may then follow. But although GDP growth is still strong in the USA, Fed policy and stretched household budgets could well see spending slow and growth fall. Stagflation is less likely in the USA than in the UK and many other countries, but there is still the danger of over-reaction by the Fed given the predicted fall in inflation.
But there are reasons to be confident that stagflation can be avoided. Supply-chain bottlenecks are likely to ease and are already showing signs of doing so, with manufacturing production recovering and hold-ups at docks easing. The danger may increasingly become one of demand being excessively dampened rather than supply being constrained. Under these circumstances, inflation could rapidly fall, as is being forecast.
Nevertheless, as Covid restrictions ease, the hospitality and leisure sector is likely to see a resurgence in demand, despite stagnant or falling real disposable incomes, and here there are supply constraints in the form of staffing shortages. This could well lead to higher wages and prices in the sector, but probably not enough to prevent the fall in inflation.
- Inflation will probably melt away in 2022 – central banks will do far more harm trying to tackle it
The Conversation, Brigitte Granville (14/1/22)
- Stagflation and why it matters
The Week, Chas Newkey-Burden (1/10/21)
- Surging inflation could dwarf other issues in the political landscape as households feel the strain
Sky News, Ed Conway (19/1/22)
- Inflation is back, and there’s plenty more in the pipeline
The Guardian, Larry Elliott (19/1/22)
- UK inflation jumps to highest level in 30 years
Financial Times, Chris Giles (19/1/22)
- UK workers’ pay rises fall behind inflation amid cost-of-living crisis
The Guardian, Richard Partington (18/1/22)
- UK faces a pay squeeze – and higher interest rates look likely
The Guardian, Phillip Inman (18/1/22)
- Inflation: why it’s temporary and raising interest rates will do more harm than good
The Conversation, Muhammad Ali Nasir (22/11/21)
- Inflation: why it is the biggest test yet for central bank independence
The Conversation, Anton Muscatelli (14/12/21)
- Three more interest rate rises loom after Bank’s borrowing cost shock
The Telegraph, Russell Lynch and Tim Wallace (16/12/21)
- US Stagflation: The Global Risk Of 2022 – OpEd
Eurasia Review, Dan Steinbock (17/1/22)
- If prices keep rising, a nightmare scenario for the US economy is a real possibility
CNN, Paul R La Monica (12/1/22)
- Will inflation in the UK keep rising?
Bank of England (10/12/21)
- Under what circumstances would stagflation be (a) more likely; (b) less likely?
- Find out the causes of stagflation in the early/mid-1970s.
- Argue the case for and against the Fed raising interest rates and ending its asset buying programme.
- Why are labour shortages likely to be higher in the UK than in many other countries?
- Research what is likely to happen to fuel prices over the next two years. How is this likely to impact on inflation and economic growth?
- Is the rise in prices likely to increase or decrease real wage inequality? Explain.
- Distinguish between cost-push and demand-pull inflation. Which of the two is more likely to result in stagflation?
- Why are inflationary expectations a major determinant of actual inflation? What influences inflationary expectations?